- Wealth PMS (50L+)
In today’s edition of Learning Technical Analysis, we’ll study a few Japanese Candlestick Patterns.
We’ve already looked at the basics of what candles are. We know that the Open and close form the body of a day’s candle, theHigh, Low are represented by the wicks and the body is filled with a colour that depicts an upmove or downmove.
Japanese candlesticks can then be organized into patterns. Let’s take a look at some of them, with an indication of whether they are bullish, bearish or otherwise.
A Doji is a day in which the body of the candle is tiny – the stock closes where it opens. The stock might have huge highs or lows of the day, leading to long wicks (or short wicks). The Doji means a layer of uncertainty – that the market opened, went in either direction but closed at around the same place.
Should the Open be exactly equal to the Close? No. Like most art forms, Japanese candlesticks leave it to you to decide. I usually consider something that looks like a Doji to be one – and typically a 0.05% to 0.1% range between the open and close will work.
A Doji by itself means little. The ‘uncertainty’ implied in a Doji is relevant if there is a strong trend, or if previous or subsequent days form interesting patterns as well. One pattern is the Doji Star.Here, the doji day lies between two big moving days in different directions. The Morning Doji Star is a bullish reversal indicator which occurs when:
You can see this in this chart:
This requires no confirmation from other indicators. The idea here is that the Doji told you about uncertainty on the downtrend. The next day’s long and opposing bar (white versus black) told you the stock was moving up.
Your trade would then have to be a reversal trade – that is, go long the stock (or buy call options, or sell put options) with a stop loss that would be below the low of the doji. See Yes Bank in this trade:
On the other side you have a doji after an uptrend. The previous bar is big and white, and the next bar is big and black. The doji has to have gapped up (that is, it needs to open above the close of the white bar). This signifies a potential reversal of trend:
The concept of both the morning and evening Doji stars are the same: That prices trend in one direction, and then there’s indecision (the Doji). That the Doji gaps out is important – the gap signifies an increase in momentum of the trend, and yet, the close is at the same as the open. Why? One important reason is that the sellers are done selling (in case of a morning Doji star) and buyers are getting in an stopping the stock going further down.
The confirmation then tells you the reversal is on and a large bar in the reverse direction confirms the trend.
This is just market flow and can thus be explained, but the candlestick pattern just gives it a name. Note that these patterns don’t happen often.
Three consecutive black bars which
indicate a sudden change of trend downwards. These are Three Black Crows, Like so:
And the reverse, with three white candles, is bullish (Three White Soldiers):
Again, this can be explained with market logic. A stock that closes up after a downtrend, then sees a lower open on the next day (due to opening selling), and then buyers push it up further. The subsequent day, again sellers make the stock open below and buyers take it up higher. This is a classic pattern which shows seller exhaustion; and what you would typically hear as “short covering” on TV because it sounds good.
I could go on and on about patterns. There are various kinds and the above lot are self-sufficient, that is, you need no “confirmations”. However we still need to know how to define a “trend” either way.
The best source I know for candlesticks is Greg Morris’ Candlestick Charting Explained. This is however very expensive now at Rs. 1,500 but is a definitive source.
Another great source is StockCharts.com.
While I highlight these patterns on charts that seem to have done exactly what they are supposed to, what about false positives?
Even if there are false positives, is it possible to “test” the candlestick theory and see if these trades have worked in the past? Can we “back test” and find out how many trades there are, how things work, and so on?
In the next series of lessons, we’ll learn exactly this. How we will create a system, how to get data for it, how to test it on various stocks or indexes and how to analyse the results.
We will, in those lessons, test some of the Japanese Candlestick patterns as well.
If you have any questions, comments or suggestions, please feel free to firstname.lastname@example.org or use the member-only google group.
Note: We haven’t been able to do our webinar for May due to time constraints. We’ll do two webinars in June. More details soon.
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mi
nd. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.